Online ‘Fairness’ Tax Could Hit Your 401(k)

Financial transaction tax proposals have prompted much debate over the past year, both in the U.S. and internationally.

In February, the European Union proposed allowing its member countries to levy taxes on the trading of stock, bonds and derivatives.

Supporters argue that in addition to raising revenue, the tax would act as a "speed limit" that reduces volatility in the markets. Opponents counter with studies showing that the revenue estimates are overstated, and that the tax could actually increase volatility.

Additional concerns include the indirect impact on middle-class investors — the tax would hit trades done by mutual funds and retirement plans such as 401(k) accounts — and the competitive effects on particular jurisdictions, as the tax creates incentives for such transactions to move across borders.

Given these concerns, one would think that the U.S. Congress would carefully debate the merits of a financial transaction tax, not rush to approve it. Yet the U.S. Senate just passed a bill that may enable states to impose their own financial transaction taxes — a recipe for increasing economic uncertainty.

Supporters of the Marketplace Fairness Act (MFA), which the U.S. Senate passed on May 6 on a 69-27 vote, claim that online retailers enjoy an unfair advantage over their brick-and-mortar competitors. The bill, they maintain, addresses this imbalance by allowing states and localities to require "remote sellers" to collect taxes for "sales" to their residents.

However, the bill is silent on the particular products and services of "sellers" and "sales" it covers. Thus, it could open the door for state and local governments to tax financial transactions they deem as "sales" on businesses throughout the country.

Financial industry trade groups, including the Financial Services Roundtable and the Securities Industry and Financial Markets Association (SIFMA), have expressed concern. "The bill could lead to unexpected costs being passed on to consumers of financial services, including sales taxes on services or state-level stock transaction taxes," SIFMA says in a statement.

Similarly, Brian Graff, executive director of the American Society of Pension Professionals and Actuaries, notes, "The legislation would allow states to impose a financial transaction tax that would apply to American workers' 401(k) contributions and other transactions within workers' accounts."

Marketplace Fairness Act proponents have failed to counter these fears. In response to a questionnaire by Americans for Tax Reform, MFA co-sponsor Sen. Mike Enzi, R-Wyo., says there's nothing to fear, because now, "no state imposes a sales tax on financial transactions."

But states have done so in the past, and the legislation would give them incentive to do so again, because it would stifle tax competition.

For an idea of what a state-level financial transaction tax would look like, the history of a 20th century tax in New York state is instructive. From 1905 to 1981, the state imposed a transfer tax on securities transactions. After a 50% increase was proposed in the 1960s, the president of the New York Stock Exchange threatened to build a second trading floor in Trenton, N.J., to bypass the New York tax.

New York settled on a 25% increase instead, but even that caused many investors and financial firms to flee. A NYSE analysis from the late 1960s noted that, "New York securities markets have experienced increasing competitive problems in recent years from regional stock exchanges located in San Francisco, Los Angeles, Chicago, Detroit, Philadelphia and Boston. . . . From 1965 through 1967, the volume of trading on the regional exchanges increased by 73.2%."

This competition prompted New York to phase out the tax starting in the 1970s. The state still collects a nominal tax, but since 1981, the proceeds have simply been returned to traders.

If the Senate version of the Marketplace Fairness Act were to sail through the House unchanged, states would have little reason to worry about financial firms fleeing. If New York were to re-impose a stock transfer tax, as some progressives propose, the state could blunt the impact of the NYSE leaving by simply classifying it as a "remote seller" and requiring it to remit taxes to state coffers for any sale that might involve a New York business or resident.

For that matter, New York and other states could also tax "remote sales" made from the BATS Exchanges in Lenexa, Kansas (a suburb of Kansas City), which now make up more than 10% of equity trading in the U.S. The possibilities are seemingly endless for states hungry for revenue or seeking to wage populist crusades against the financial industry.

Middle-class savers would lose out as hidden taxes chip away at their 401(k)s, mutual funds, and brokerage accounts.

So would U.S. competitiveness. A uniform tax from EU countries would look mild to international investors in comparison to an unpredictable tax regime of varying tax rates on financial transactions from several different states.

Despite warnings, the Senate brushed aside these dangers to the U.S. financial system as it rushed through the Marketplace Fairness Act.

To borrow a phrase from investing, the House needs to undertake some much-needed due diligence on the bill before it completes the transaction of passage.